This is fascinating. Finance Professor and creator of the Efficient Markets Hypothesis Eugene Fama:

The premise of the Fox book [“The Myth of the Rational Market”] is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH)…

The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH.

I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it’s pretty clear I’m in the minority. If the EMH took over the investment world, I missed it.

This gets to something like the Grossman-Stiglitz paradox, which is if markets reflect all information, where’s the incentive to get the information needed to keep markets efficient? The “keeping” part is key there, since the real economy is always changing, someone needs to do something to “keep” the financial markets forecasting capital needs efficiently. It’s a weird theoretical place to end up.

But he’s right. Most market participants don’t think markets are so efficient that they can’t get some alpha out of it. So who does believe in market efficiency? Is there a group of people who believe it significantly more than Fama believes people that participate in markets believe it? Yes: Our regulators and our government.

You can see it in Judge Easterbrook’s statement on mutual fund fees, where since “It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest” any observed difference between institutional and individual investor fees has to be the result of costs, as opposed to bargaining. It’s easy to read that differential the other way, that institutional investors have clout and individuals are getting squeezed, but since we take efficient markets to be true we start from the ideological other stance.

You also hear it in the background in other places. Let’s look at July 30, 1998 RR-2616, Treasury Deputy Secretary Lawrence Summers testimony before a Senate Committee on the CFTC Concept Release. As a reminder, the CFTC, under Brooksley Born, wanted authority to regulate OTC derivatives. The Treasury (Rubin and Summers), SEC (Arthur Levitt) and The Federal Reserve (Alan Greenspan) wanted to stop this, and did. Born resigned and was replaced by one of Rubin’s assistants.

(By the way, there’s an excellent Frontline episode about this clusterfuck that is worth your time. My favorite is the gendered language here: “I didn’t know Brooksley Born,” says former SEC Chairman Arthur Levitt, a member of President Clinton’s powerful Working Group on Financial Markets. “I was told that she was irascible, difficult, stubborn, unreasonable.”

I can only assume this is Ivy League-speak for “What? You believe a random firm could take on such a CDS position in the OTC market that their counterparty risk would destabilize the entire system? Why don’t you talk reasonably with us in a few days when you are off the rag.”)

Summers: Mr Chairman, thank you for giving me the opportunity to discuss issues raised recently regarding the regulation of the OTC derivatives market — notably, the concept release issued last May by the Commodity Futures Trading Commission (“CFTC”)…

Once again, it is legitimate and valuable for Congress to consider whether it is necessary to make changes to the regulation of the entire OTC derivatives market. But I would note that it is not immediately obvious how either of these rationales applies in the case of the vast majority of OTC derivatives:

* first, the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;

Ah, the late 1990s. “Yes there are some noise traders sloshing around out there but the idea that the financial sector wouldn’t get counterparty solvency risk perfect is outside the terms of reasonable debate.” There’s a lot of stuff going on there, hubris, subsequent cushy jobs at hedge funds and large banks, not rocking the boat, etc. But underlining this, for regulators, members of Congress, officials more generally, is the idea that markets will simply get this correct. And they did not.

Justice Holmes once famously dissented that it’s a form of judicial activism to base our courts on “an economic theory which a large part of the country does not entertain.” It seems like the same should be said for our government and our regulatory bodies, especially as they try and figure out how to fix the mess that is the financial markets. And it’s worth noting that the founder of this economic theory, The Efficient Markets Hypothesis, doesn’t even believe that people actually in the financial markets entertain it.

17 Responses to Who believes market efficiency?

Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient.

This is a beautifully weird sentence and I’ll bet Fama didn’t even do it on purpose. Why did he drop in the phrase about the big fund inflows? To reinforce the credibility of hedge funds, right?

But why would anyone believe that big fund inflows indicated that hedge funds were doing something right, unless they already believed that the people deciding where to place their funds were, at least collectively, rational? The market’s assumed efficiency is what gives credibility to its own belief in its own inefficiency.

You can step outside this logic loop and observe that any entity that believes in its own fallibility must be right (about that). If the market were truly efficient, all those entities couldn’t make a profit, and therefore the market, being efficient, wouldn’t invest in them. Either they do make risk-adjusted profits, in which case there must be inefficiencies for them to exploit in order to do so, or they don’t, in which case any capital flowing into them is itself an inefficiency.

Except that isn’t what he’s saying: he’s pointing at the fact that the market believes (through capital allocation) in its own inefficiency, *without* realizing that that belief is self-vindicating. Ironically, the very fact that the market rejects EMH proves EMH wrong.

Summers is no assuming marketS are efficient. He’s assuming these particular markets have highly informed and competitive participants. These facts (if true) would suggest little room for effective regulation, i.e. there’s no market power issues and no information issues.

Its logically possible for EMH not to hold and there still be no opportunity for effective regulation. Similarly, even if EMH holds, informational efficiency doesn’t imply Pareto efficiency. The truth status of EMH says nothing about the necessity of regulation.

RE “the very fact that the market rejects EMH proves EMH wrong.”

No it doesn’t. That I believe there’s no gravity doesn’t mean I can fly. EMH is a statement about the existence of exploitable arbitrage opportunities not about the beliefs of market participants.

“[t]he Fourteenth Amendment does not enact Mr. Herbert Spencer’s Social Statics.” !!! I love that guy. If you haven’t, you should read The Metaphysical Club – you get a whole new respect for Wendell Homles Jr. (and William James, and Charles Pierce, and by extension Richard Rorty!).

Will,

So you would have canned Brooksley Born too?

Chris,

I had to chart out your comment on a piece of paper, but I finally got it. Well put.

It seems the hedge funds say that markets are inefficient enough for them to make excess returns, but efficient enough that they are doing a valuable service to the economy and keeping prices close to fundamental values.

“Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications”. [1]

From the same paper, two of the assumptions of the CAPM are:

“The first assumption is COMPLETE AGREEMENT: given market clearing asset prices at t-1, investors agree on the joint distribution of asset returns from t-1 to t. And this distribution is the true one, that is, the distribution from which the returns we use to test the model are drawn”. (My capitulars).

For those not too familiar, this is the Efficient Market Hypothesis (EMH).

Now, if a model derived from the EMH fares poorly in empirical tests, then I would say the EMH from which it derives becomes suspicious. Thus, Prof. Fama’s claim (“I continue to believe the EMH is a solid view of the world for almost all practical purposes”) is surprising, to say the least.

Still following the text above, Prof. Fama also claims that “most investing is done by active managers who don’t believe markets are efficient”.

If financial practitioners have abandoned the EMH -as Prof. Fama claims, without providing any evidence- it is a predictable and indeed understandable consequence of this poor performance of the CAPM, as measured by Prof. Fama himself.

But this disuse of the EMH has an striking consequence: if financial practitioners have abandoned the EMH, then in the terms used by Prof. Fama to describe the EMH, “there is NO complete agreement”…

So, we move full-circle and fall into what, to me, seems like a logical contradiction.

Note also that in a paper widely acknowledged as one of the foundational texts of modern economics, Prof. Friedman states that economics is a positive science [2]. By this it is meant that economics, among other things, is purported to describe economic phenomena which are independent of human desires. According to this view, the EMH empirical validity should not depend on financial practitioners deliberately following the EMH.

In this context, Prof. Fama’s statements (“Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH”) seem not only oddly irrelevant, but they also seem to imply that the EMH is valid, only if people think it’s valid.

These contradictions, by the way, seem to plague many defenses of the EMH. Prof. Robert Lucas, another renowned economist, has recently defended the EMH in the following terms: If people knew a bubble was going to burst next week, they would act accordingly now, bursting the bubble now, not next week.

Unfortunately, the text containing this defense (R. Lucas. “In defense of the dismal science”. From The Economist print edition. Aug 6th 2009 [3]) is currently subscribers’ content only. Anyway, for those subscribers, I include the link below.

One observes in Prof. Lucas’ reasoning the same circularity present in Prof. Fama’s. As in Prof. Fama’s reasoning, Prof. Lucas seems to acknowledge that bubbles exist, although the EMH implies that bubbles cannot exist. This in itself seems like another contradiction, to me.

But, on top, this reasoning is factually flawed: people did know the bubble was going to burst, they acted accordingly, and the bubble did not burst as a consequence. Instead, it went on growing until it was ready to burst by itself.

Dirk Bezemer, in a recent paper [4], identifies 12 economists who did see the current crisis coming.

I happen to think the markets are pretty efficient, but not in a classical EMT sense. First, the markets are efficient at incorporating available (and relevant) information. Without the “available” part, it doesn’t make sense to go prospecting for informational advantages (as doing so implies that you can find “unavailable” data that isn’t reflected in the market price but would affect it once disclosed, giving you a leg up). So if you can find info that’s not available (a nuke bomb will hit company HQ in 20 minutes), you’ll have an edge (note: whether this is considered insider trading or not will depend on the particular example of the info you uncover). What I think happens: many go looking for this informational advantage; few find it, but many think they do. And so most times the managed funds don’t outperform the indexes.

The other problem with EMT: it completely disregards sentiment, irrationality, hope — all those lousy emotions humans are riddled with. So I would prefer a sort of “big tent” EMT (maybe Andrew Lo-type stuff, though I’ve got to read more about his thinking). Namely bubble markets are efficient in some way (if enough investors really think the Net will grow at 100% a year and will transform the world and there’s too little supply of stock to meet demand — the bizarro price is efficient based on these wild expectations, though it doesn’t make much sense perhaps to a minority of cool-headed investors).

So I would shovel in all this irrationality, and given all this, say the markets are “efficient.” Of course this isn’t what traditional EMT’ers mean, so I’m way off the reservation I suppose. But the paradox I think that needs resolving is: (1) It’s very hard to beat the market (thus it’s efficient) (2) Market prices often don’t make sense, and perhaps for long periods of time too (thus it’s inefficient). Trouble is, the market can not make sense for longer than you have money to bet against it (ah, what’s that famous quote … I forget). Apols for running long — I’ve been wanting to blog on the EMT subject for a while now, but I just know it would get SOOOO long. 🙂

A possibly more understandable formulation of my previous point: Hedge funds amount to hiring someone to pick up $20 bills off the ground. This is not a sensible endeavor unless you believe there are some. Therefore, the markets are either dumb enough to leave some $20 bills on the ground, or dumb enough to hire people to pick them up when they don’t exist.

Prof. Friedman states that economics is a positive science. By this it is meant that economics, among other things, is purported to describe economic phenomena which are independent of human desires.

This is self-contradictory. In order to be a positive science, economics must study phenomena that exist. Almost all existing markets involve the behavior of human beings. (Very few people are working in capuchin monkey economics, but for those that are, it actually is independent of human behavioral patterns — but not of capuchin monkey behavioral patterns. Theoretically you could find that human economics and monkey economics are as different as the physical properties of steel and ice, although I don’t know if they actually are *that* different.)

Some economists do try to produce necessarily true statements about economics that purportedly don’t depend on the psychology of the species comprising the market, but this attempt has so far been an abject failure. Usually it relies on substituting a theoretical psychology that doesn’t resemble any actual market-making species and then ignoring differences between the behavior of markets of theoretical entities and markets of real organisms.

In order to be a positive science, you have to put down the theoretical toy universe and start studying reality.

“Namely bubble markets are efficient in some way (if enough investors really think the Net will grow at 100% a year and will transform the world and there’s too little supply of stock to meet demand — the bizarro price is efficient based on these wild expectations, though it doesn’t make much sense perhaps to a minority of cool-headed investors).”

And it’s efficient to build tons of houses east of sacramento too I assume?

This current housing bubble cannot be efficient, there is no way that was the most efficient allocation of capital, which is the main economic benefit of financial development. Banks made a lot of loans where MB<MC and this misallocation set in motion a chain of events where we currently have over 10% unemployment. Japan's lost decade also happened right after the popping of its dual stock-housing bubbles. This was hardly efficient as well, no matter how you slice it. Just look at Reinhart-Rogoff's stuff like “Is the 2007 U.S. Subprime Crisis So Different? An International Historical Comparison.” Financial crises are often precipitated by bubbles, and they have long lasting, scarring effects on the economy. (See also Manias, Panics and Crashes for historical examples).

The Efficient Markets Hypothesis requires that a “market” meet various assumptions to actually be efficient.

The implicit (now explicit) “Too Big To Fail” doctrine, evidenced for example by the Long Term Capital Markets bailout, invalidates the assumptions of the Efficient Market Hypothesis in major modern US financial markets.

Conservative, business, and libertarian sources, not to mention folks like Eugene Fama, frequently equate the actual “market” with “free market” or a hypothetical “efficient market” without actually demonstrating that the assumptions required to assert that a market is “free” or “efficient” apply.

Of course, with massive overt subsidies to Goldman Sachs, JP Morgan Chase, Citigroup, and the other major banks, US financial markets are light years from a “free” or “efficient” market, even in theory.

There are really at least two issues:

1. Would markets actually be “efficient” if the assumptions required by the various forms of the Efficient Market Hypothesis clearly applied?

2. Do the assumptions actually apply to the real market (obviously not today).

“And it’s efficient to build tons of houses east of sacramento too I assume?”

If you expect tons of people and tons of demand for houses east of Sacramento, sure. Look, in hindsight, we all pretty much agree it wasn’t efficient. I was among the loudest in South Florida screaming about the insanity of home prices down there from 2003-2006. But at the time, under the prevailing beliefs, it all seemed to make sense to a lot of people — or it wouldn’t have been done. Sure, some of us were smarter, but most weren’t. Right now I’m sure there are allocations of capital that seem very efficient, but may not look that way in 10, or 20, or 50 years, for whatever reasons.

Anyway my larger point was that stock prices move rather “efficiently” on the basis of available information and prejudices and irrationalities and superstition and a whole bunch of junk that’s not normally part of EMT. That’s what makes it so darn hard to beat the market. But I’m not necessarily trying to argue that the price is efficient in the sense that it represents any sort of “true value” that then directs capital to its best use. Imagine if 99% of a superstitious population thinks the great god Rah is going to throw a fireball at Earth in five years and the stock of Great Fireball Shields Inc. jumps 8,000 percent. That may be an utterly stupid allocation of resources, but the price may smoothly and efficiently change over time to reflect the broad-based fears of an ignorant population, among other things.

Yes i think we are using two forms of efficient, one about allocating capital and one about beliefs. I think the latter is closer to a concept of rationality, that investors were rational to expect increases in housing demand. It can be rational for investors to think ex-ante that building lots of houses in the desert around Phoenix is profitable, but this is obviously a poor allocation of capital hence inefficient. Maybe this is because I’m coming from a macro perspective, but I can’t see how financial markets can be “efficient” while allocating capital poorly.

And I thought that efficient markets meant that underlying values were based on fundamentals, so any irrationality is arbitraged away by the rational part of the market. If everyone is irrational, or rational arbitrageurs can’t return the market to fundamental values, it’s not strong form EMH.

Agree that it’s not strong form EMH. I definitely don’t believe in a rational market where the sane can arbitrage away the insanity (in fact, what we find instead is that, after the rational guys fail on say their short plays, they jump in and partake of the insanity, trying to time the leap out later so they don’t get burned). I think the market is efficient in a sense, but I know my use of “efficient” is sort of special and can be confusing.

“Some economists do try to produce necessarily true statements about economics that purportedly don’t depend on the psychology of the species comprising the market, but this attempt has so far been an abject failure. Usually it relies on substituting a theoretical psychology that doesn’t resemble any actual market-making species and then ignoring differences between the behavior of markets of theoretical entities and markets of real organisms.”

I believe you are close to the answer.

The problem, as I see it (and this is merely my personal opinion), is that, once the model fails (as it did in Prof. Fama’s own 2004 study) most economists blame reality for not following the model (as Prof. Fama seems to do in the statement quoted above). This psychological reaction has a name: denial.

In the context of intellectual debate (as in the present exchange of ideas on Prof. Fama’s statement), this denial is merely “bizarre” and has not consequences by itself.

But intellectual debate is not isolated from policy and when flawed models are applied -just because authority figures are in denial- people get hurt, as we have seen.

The current practice in economic research is obviously the opposite of what science is supposed to be: once the model fails empirical testing, then it should either be modified (if there is something that can be salvaged) or discarded altogether.

And one would not rush to apply economic models to policy-making, without having strong empirical reasons to believe they actually work.

On a separate note: the very notion of efficiency, as used in economics, does not make sense. It’s used in all sorts of different contexts to denote entirely different things.

Some form of “efficiency” may make sense for simple systems: a car’s fuel-efficiency, for instance. But it does not make sense for an economic system with infinite outputs and inputs. But I’ll leave this for another occasion.